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Sovereign risk and fiscal (in)attention a look at the US State default of the 1840's

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Presentation from ADEMU Fiscal Risk and Public Sector Balance Sheets Conference at the University of Bonn, July 6-7

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Sovereign risk and fiscal (in)attention a look at the US State default of the 1840's

  1. 1. SOVEREIGN RISK AND FISCAL (IN)ATTENTION: A LOOK AT THE U.S. STATE DEFAULT OF THE 1840S Huixin Bi & Nora Traum Federal Reserve Bank of Kansas City & North Carolina State University July 2017 The views expressed in this paper are those of the authors and not of the Federal Reserve Bank of Kansas City, or the Federal Reserve System.
  2. 2. MOTIVATION • European sovereign crisis: • How did the sovereign interest rate hikes relate to country-specific fiscal fundamentals? • Did investors change their pricing behavior during the crisis? If so, why? • How did the sovereign risk spread in the union?
  3. 3. MOTIVATION • European sovereign crisis: • How did the sovereign interest rate hikes relate to country-specific fiscal fundamentals? • Did investors change their pricing behavior during the crisis? If so, why? • How did the sovereign risk spread in the union? • Sargent’s Nobel Prize lecture: • “United States then, Europe now” • This presentation gives an interim report towards: • Use U.S. state default (8 states and 1 territory) in the 1840s ... • ... to explore questions relevant for policymakers today.
  4. 4. FINDINGS • Non-defaulting vs. defaulting states had distinct fiscal policies/fundamentals before the crisis • Ohio and New York: more careful and responsible • Indiana and Pennsylvania: over optimistic or irresponsible
  5. 5. FINDINGS • Non-defaulting vs. defaulting states had distinct fiscal policies/fundamentals before the crisis • Ohio and New York: more careful and responsible • Indiana and Pennsylvania: over optimistic or irresponsible • ... But no significant difference in bond prices before the crisis
  6. 6. FINDINGS • Non-defaulting vs. defaulting states had distinct fiscal policies/fundamentals before the crisis • Ohio and New York: more careful and responsible • Indiana and Pennsylvania: over optimistic or irresponsible • ... But no significant difference in bond prices before the crisis • Investors’ attention to fiscal fundamentals seemed to depend on the economic condition • Evidence from newly constructed fiscal information index from newspaper coverage of fiscal policy from 1834/1 to 1845/12 • Higher fiscal information index (i.e. more and better coverage) during the crisis • Fiscal index’s ability to predict bond prices varies before vs. during the crisis
  7. 7. FINDINGS • Non-defaulting vs. defaulting states had distinct fiscal policies/fundamentals before the crisis • Ohio and New York: more careful and responsible • Indiana and Pennsylvania: over optimistic or irresponsible • ... But no significant difference in bond prices before the crisis • Investors’ attention to fiscal fundamentals seemed to depend on the economic condition • Evidence from newly constructed fiscal information index from newspaper coverage of fiscal policy from 1834/1 to 1845/12 • Higher fiscal information index (i.e. more and better coverage) during the crisis • Fiscal index’s ability to predict bond prices varies before vs. during the crisis • One potential explanation • Costly information processing [in the spirit of rational inattention, Sims(2003)] • Investors pay less attention to fiscal news in good times
  8. 8. UNITED STATES IN 1840 • 8 states and 1 territory defaulted between 1841 and 1843
  9. 9. U.S. STATE BOND PRICES (1820-60) Jan20 Jan25 Jan30 Jan35 Jan40 Jan45 Jan50 Jan55 Jan60 0 20 40 60 80 100 120 140 OH KY NY IN IL MD PA Source: Sylla, Wilson, and Wright (2002) background
  10. 10. Background: The Role of Fiscal Fundamentals
  11. 11. RISING STATE DEBTS • Outstanding state debt by 1841 was $198 million, with more than half incurred after 1836 • Northeastern/western states: internal improvement projects • Southwestern states: chartered state banks State Date of % of Debt to Default Banking (1841) Indiana January 1841 19% Florida January 1841 98% Mississippi March 1841 100% Arkansas July 1841 100% Michigan July 1841 0% Illinois January 1842 22% Maryland January 1842 0% Pennsylvania August 1842 0% Louisiana February 1843 93% Source: English (1996), House Report No. 296 to 27th Congress (1843) more
  12. 12. DEBT OUTSTANDING ON SEPTEMBER 1, 1841 BY YEARS OF AUTHORIZATION ’30−’32 ’33−’35 ’36−’38 ’39−’41 0 0.5 1 1.5 2 2.5 3 3.5 4 x 10 4 ThousandsofDollars IL IN KY OH MD NY PA Source: William Cost Johnson House Report No. 296 to 27th Congress (1843) more
  13. 13. JUSTIFYING STATE DEBTS • Increasing land values were a key factor underlying the massive state borrowing • Expectation of property tax revenue (especially important for “new” states) 1835 1836 1837 1838 1839 1840 1841 1842 1843 1844 1845 1846 1847 1848 1849 1850 Year 4 6 8 10 $peracre Land price in Indiana Source: Indiana Annual Auditor Reports for various years • Early success of New York (1817) and Ohio (1825) canals
  14. 14. DEFAULTERS VS. NON-DEFAULTERS Literature and historical documents reveal distinct policies crucial for fiscal outcomes. • Non-Defaulters • Ohio and New York: taxes and funded canal funds dedicated to improvement projects; good credit history • New York: dramatic austerity measures (Stop and Tax Law in March 1842)
  15. 15. DEFAULTERS VS. NON-DEFAULTERS Literature and historical documents reveal distinct policies crucial for fiscal outcomes. • Non-Defaulters • Ohio and New York: taxes and funded canal funds dedicated to improvement projects; good credit history • New York: dramatic austerity measures (Stop and Tax Law in March 1842) • Defaulters • Pennsylvania and Maryland: borrow-as-you-go policy (pay interest with more borrowing, and delay taxing until default) “An act to repeal the State tax on real and personal property, and to continue and extend the improvements of the State... ” – Pennsylvania Bank Improvement Act of 1836 (printed in several newspapers) • Indiana: over-optimistic fiscal forecasts
  16. 16. INDIANA: OVER-OPTIMISTIC FISCAL FORECASTS • Land taxes were crucial for Indiana: 40% of total tax revenue in 1835 vs. 84% in 1838 • Fiscal forecast assumptions in 1836 (to authorize $10 million bond, compared to its annual revenue of about $50,000): • Value of taxable property would grow at 15% annually (only 4.4% ex-post) • Set up a dedicated sinking fund with return of 9% (didn’t happen before default) 1836 1838 1840 1842 1844 1846 1848 Year 0 100 200 300 400 LandTaxRevenue(thousands) Actual Forecast Source: Indiana Report of the State Board of Internal Improvement (1836)
  17. 17. Newspapers & Information • Historical documents show defaulters vs. non-defaulters had distinct fiscal policies before the crisis • Debt more than doubled in 1836-1838 relative to preceding three years. • How were investors thinking about fiscal fundamentals during this period?
  18. 18. FISCAL INFORMATION INDEX • Construct index of newspaper articles related to fiscal information • Monthly counts of articles with {tax} and {debt} and name of state from Gale digitized databases: • the 19th century U.S. newspapers database • the 19th century British newspapers database • the Times London archive 1785-2010 • Focus on seven states: Indiana, Illinois, Maryland, Pennsylvania, New York, Ohio, and Kentucky • Index for each state and composite index from sum of all states • Divide the count for each month by the count of all articles written • Penny newspaper in the 1830s
  19. 19. FISCAL INFORMATION INDEX 138 Newspapers included • 91 within U.S. • 84 from contemporary states (as of 1840), 7 from territories • 47 within U.K. • England: 39; Scotland: 5; Ireland: 2; Wales: 1 • Example: New York • New York Herald, New York Spectator, Emancipator and Free American, Log Cabin, Voice of Freedom, Weekly Herald • Herald included a “money article” by 1835 which Mott (1950) credits as precursor to modern financial page
  20. 20. FISCAL INFORMATION INDICES Jan34 Jan36 Jan38 Jan40 Jan42 Jan44 0 20 40 60 80 Article Counts OH KY NY IN IL MD PA Jan34 Jan36 Jan38 Jan40 Jan42 Jan44 0 100 200 300 400 500 600 Article Indices with Normalization • Article indices at monthly frequency
  21. 21. DATA ANALYSIS Test for breaks in the coverage of newspaper articles by estimating Markov-switching model: It = µ(st) + σ(st) t • Allow for two regimes in estimation • It: fiscal information indices • µ(st): average level of index in regime st • σ(st): volatility of index in regime st
  22. 22. RAW MONTHLY COMPOSITE INDEX MARKOV-SWITCHING ESTIMATION • µ and σ significantly different across regimes µ(low) µ(high) σ(low) σ(high) pll phh SBIC (1) 59.21*** 179.93*** 34.52 0.94 0.78 10.56 (3.41) (7.96) (2.19) (0.02) (0.08) (2) 54.30*** 152.49*** 28.37 56.65 0.96 0.90 10.44 (3.17) (10.27) (2.28) (6.42) (0.02) (0.05) • Probability of low article count regime Jan34 Jan35 Jan36 Jan37 Jan38 Jan39 Jan40 Jan41 Jan42 Jan43 Jan44 Jan45 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
  23. 23. RAW MONTHLY COMPOSITE INDEX MARKOV-SWITCHING ESTIMATION • µ and σ significantly different across regimes µ(low) µ(high) σ(low) σ(high) pll phh SBIC (1) 59.21*** 179.93*** 34.52 0.94 0.78 10.56 (3.41) (7.96) (2.19) (0.02) (0.08) (2) 54.30*** 152.49*** 28.37 56.65 0.96 0.90 10.44 (3.17) (10.27) (2.28) (6.42) (0.02) (0.05) • Probability of low article count regime Jan34 Jan35 Jan36 Jan37 Jan38 Jan39 Jan40 Jan41 Jan42 Jan43 Jan44 Jan45 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
  24. 24. FISCAL INFORMATION ROLLING-WINDOW INDICES Jan34 Jan36 Jan38 Jan40 Jan42 Jan44 100 200 300 400 500 600 Article Counts OH KY NY IN IL MD PA Jan34 Jan36 Jan38 Jan40 Jan42 Jan44 100 200 300 400 Article Indices with Normalization • RW indices of accumulated counts for past 12 months (low frequency fiscal news)
  25. 25. FISCAL INFORMATION INDEX • Regime change in the amount of fiscal news reports: • More fiscal news reports available in general during the crisis • Regime change in the cyclical pattern of fiscal news reports: • More relevant fiscal news during the crisis • More reports published following the publication dates of State Auditor and Treasury reports
  26. 26. BOND PRICES & FISCAL INFORMATION INDEX • Did the fiscal information index affect bond prices? • Estimate following equation over period Jan. 1834 to Dec. 1845: ln pb it = β0 + β1Irw t + βr 1Irw t dRt + β2 ln pb it−1 + βr 2 ln pb it−1dRt +β3zit + βr 3zitdRt + it • pb it: bond prices • Irw t : rolling-window fiscal index • dRt: crisis dummy (January 1839) • zit: control variables
  27. 27. DATA: BOND PRICES • Data from Price Quotation database of Sylla, Wilson, and Wright (2002) • market prices from contemporary newspapers over 1790-1860 in seven markets: London, New York, Philadelphia, Boston, Baltimore, Richmond, and Charleston • average price quotes within month to get monthly series Number of bonds for each state MD: 13 PA: 34 IN: 24 IL: 27 KY: 16 OH: 25 NY: 95
  28. 28. DATA: BOND PRICES Jan30 Jul32 Jan35 Jul37 Jan40 Jul42 Jan45 Jul47 Jan50 Jul52 40 50 60 70 80 90 100 110 120 130 New York • New York bond prices in New York market
  29. 29. DATA: BOND PRICES Jan30 Jul32 Jan35 Jul37 Jan40 Jul42 Jan45 Jul47 Jan50 Jul52 30 40 50 60 70 80 90 100 110 120 130 Maryland • Maryland bond prices in Baltimore market More States
  30. 30. DATA: BOND PRICES • Calculate average price of state bond across securities • linearly interpolate missing points between individual securities • take average across all securities
  31. 31. REGRESSION RESULTS: JAN. 1834 TO DEC. 1845 ln pb it = β0 + β1Irw t + βr 1Irw t dRt + β2 ln pb it−1 + βr 2 ln pb it−1dRt +β3zit + βr 3zitdRt + it Coefficient Specification (1) (2) (3) (4) (5) RW fiscal index, β1 0.14*** 0.00014 0.00023 -0.0015 -0.0016 (0.027) (0.0010) (0.0012) (0.0020) (0.0019) RW fiscal index X crisis dummy, βr 1 -0.30*** -0.012*** -0.012*** -0.010*** -0.0098*** (0.069) (0.0032) (0.0028) (0.0032) (0.0032) Lagged bond price 0.99*** 0.99*** 0.95*** 0.95*** (0.005) (0.008) (0.011) (0.015) Lagged bond price X crisis dummy 0.051*** 0.051*** (0.014) (0.011) Lagged Commodity price -0.048*** -0.049*** -0.023*** -0.023*** (0.0079) (0.0092) (0.0045) (0.0058) Lagged Commodity price X crisis dummy -0.052*** -0.052*** (0.014) (0.012) Lagged S&P 500 Index -0.0016 0.0027 (0.011) (0.0074) Lagged S&P 500 Index X crisis dummy 0.0030 (0.0057) RW fiscal index in crisis: β1 + βr 1 -0.16*** -0.012*** -0.012*** -0.012*** -0.011*** N 576 572 572 572 572 Adjusted R2 0.54 0.99 0.99 0.99 0.99 State-fixed effect Yes Yes Yes Yes Yes
  32. 32. REGRESSION RESULTS: JAN. 1834 TO DEC. 1845 ln pb it = β0 + β1Irw t + βr 1Irw t dRt + β2 ln pb it−1 + βr 2 ln pb it−1dRt +β3zit + βr 3zitdRt + it Coefficient Specification (1) (2) (3) (4) (5) RW fiscal index, β1 0.14*** 0.00014 0.00023 -0.0015 -0.0016 (0.027) (0.0010) (0.0012) (0.0020) (0.0019) RW fiscal index X crisis dummy, βr 1 -0.30*** -0.012*** -0.012*** -0.010*** -0.0098*** (0.069) (0.0032) (0.0028) (0.0032) (0.0032) Lagged bond price 0.99*** 0.99*** 0.95*** 0.95*** (0.005) (0.008) (0.011) (0.015) Lagged bond price X crisis dummy 0.051*** 0.051*** (0.014) (0.011) Lagged Commodity price -0.048*** -0.049*** -0.023*** -0.023*** (0.0079) (0.0092) (0.0045) (0.0058) Lagged Commodity price X crisis dummy -0.052*** -0.052*** (0.014) (0.012) Lagged S&P 500 Index -0.0016 0.0027 (0.011) (0.0074) Lagged S&P 500 Index X crisis dummy 0.0030 (0.0057) RW fiscal index in crisis: β1 + βr 1 -0.16*** -0.012*** -0.012*** -0.012*** -0.011*** N 576 572 572 572 572 Adjusted R2 0.54 0.99 0.99 0.99 0.99 State-fixed effect Yes Yes Yes Yes Yes
  33. 33. Potential Explanation: Information Processing
  34. 34. SIMPLE TWO-PERIOD MODEL • Costly information processing [in the spirit of rational inattention, Sims (2003))] • fiscal fundamentals are latent variables • more resources to process information → know more about fiscal fundamentals • Land value follows a Markov-switching model with known transition probabilities • Fiscal fundamentals and land value jointly determine sovereign default
  35. 35. SIMPLE TWO-PERIOD MODEL L0 = Lx L1 = Lh (ss, Lh) → ∆1 = 0 w/ strong fiscal state (sw, Lh) → ∆1 = 0 w/ weak fiscal state w/ prob of p xh L1 = Ll (ss, Ll) → ∆1 = 0 w/ strong fiscal state (sw, Ll) → ∆1 = δ w/ weak fiscal state w/ prob of 1 − p xh
  36. 36. SIMPLE TWO-PERIOD MODEL Household optimization: max E0 {u(c0) + βu(c1)} s.t. y0 = c0 + i0 + q0(j)b0(j)dj c1 = (1 − ∆1(j)) b0(j)dj • simple assumption: prob. of identifying weak fiscal fundamental is i0 y0 Expected consumption next period: E0c1 = b0 pxh + (1 − pxh ) i0 y0 + (1 − δ) 1 − i0 y0 • pxh : probability of high land value • δ: haircut if default
  37. 37. SIMPLE TWO-PERIOD MODEL Optimal resources devoted to processing information are state dependent: i0 y0 = max 0, 1 − 1 δ β + 1 2β + 1 1 1 − pxh • If L0 = Lh , higher prob. of high land value next period → smaller i0 y0 • If L0 = Ll , lower prob. of high land value next period → higher i0 y0
  38. 38. Wrap Up • Policy implications: • Fiscal (in)attention can play a key role in determining debt dynamics. • To do list: • Refine the construction of fiscal indexes. • Better control variables for the macroeconomy conditions for the regressions. • Examine dissemination of information.
  39. 39. SOME ECONOMIC BACKGROUND • Crisis of 1837: • Banks suspend convertibility of bank notes to specie for a year (after May 1837) • Economy recovered in 1838 • Ongoing debate on the causes: • international factors [Temin (1969)] • politics: bank war between Jackson and Biddle • policies & interbank transfers depleted reserves [Rousseau (2002)] • Crisis of 1839: • Banks suspended converting bank notes from Oct 1839 to 1842 • State debts were at the heart of the crisis return
  40. 40. POSSIBILITY OF BAILOUT • Some discussion about federal government bailout in the early 1840s • In late 1839, European investors started discussing the possibility • In December 1841, President Tyler in his message of 1841 declared no national pledge • In 1842, European investors refused to lend to the federal government unless it assumed the state debts • In December 1842, a select committee of the House investigated the advisability of federal assumption, which failed in the Congress • However, no evidence that investors expected a bailout ex-ante when purchasing bonds • European investors viewed U.S. State bonds as a safe investment • No bailout expectation ex-ante based on correspondence between European investors
  41. 41. POSSIBILITY OF BAILOUT • McGrane (1935): Correspondence between Barings (British bank) and Hope (Dutch bank) “(the twenty-six states were) all sovereign and independent, and although circumstances might in time enable the general government to aid the states, that government has no power or right to interfere.” – Barings to Hope, May 27, 1842 “... the buyers of American state stocks never contemplated until lately that the general government was in any way accountable or that it would or could interfere with them. ” – Barings to Hope, June 10, 1842 American securities in 1830s “... were subject to less frequent fluctuations in price. This appealed to the British, for they purchased these stocks as a safe and more or less permanent investment and not for speculative purposes.” – McGrane, 1935 return
  42. 42. POSSIBILITY OF BAILOUT • Chisholm v. Georgia (1793): • A citizen of South Carolina sued the state of Georgia for nonpayment of a debt • The first Supreme Court found against the state of Georgia • As a response, Congress passed the 11th Amendment to the Constitution and made it very difficult for creditors to force states to repay debts: “The judicial power of the United States shall not be construed to extend to any suit in law or quity, commenced or prosecuted against one of the United States by citizens of another state, or by citizens or subjects of any foreign state.” return
  43. 43. UNITED STATES: DEFAULT, RESUMPTION, AND REPUDIATION State Data Resumed or Date Repudiated Indiana January 1841 Resumed July 1847 Florida January 1841 Repudiated February 1842 Mississippi March 1841 Repudiated February 1842 Arkansas July 1841 Resumed July 1869 Repudiated July 1884 (Holford Bonds) Michigan July 1841 Resumed January 1846 Partially Repudiated July 1849 Illinois January 1842 Resumed July 1846 Maryland January 1842 Resumed July 1848 Pennsylvania August 1842 Resumed February 1845 Louisiana February 1843 Resumed 1844 Repudiated unknown Source: English (1996) return
  44. 44. BONDHOLDERS Bondholder Share Currency Share State Year Total Debt In Out Foreign In Out (mil dollar) State State Country State State New York 1843 26.0 0.54 0.04 0.42 Ohio 1841 12.46 0.33 0.63 0.04 0.11 0.89 Kentucky 1842 5.56 0.51 0.49 0.00 0.22 0.78 Pennsylvania 1842 34.45 0.28 0.03 0.69 Maryland 1841 16.0 0.48 0.52 Ohio 1853 0.33 0.67 Kentucky 1853 0.5 0.5 Pennsylvania 1853 0.34 0.66 Maryland 1853 0.45 0.55 Indiana and Illinois 1853 0.25 0.75 Source: Hunt’s Merchants Magazine, State Annual Auditor Reports, William Cost Johnson House Report, Wilkins (1989) return
  45. 45. OHIO LIABILITIES AS OF 1842 BY YEAR ISSUED ’25 ’26 ’27 ’28 ’29 ’30 ’31 ’32 ’33 ’34 ’35 ’36 ’37 ’38 ’39 ’40 ’41 0 0.5 1 1.5 2 2.5 x 10 6 In State Out of State Source: Ohio Annual Report of the Auditor of State, 1842 return
  46. 46. ATTITUDES TOWARDS U.S. STATE DEBT BEFORE VS. AFTER 1839 “Pennsylvania ... is the gainer, and her inhabitants will bless the (internal improvement) policy which she is pursuing. Maryland is following fast in the steps of her sister and has in progress works of the grandest order, and benefits of which will be felt by those yet unborn. Virginia, Ohio, New York, New Jersey, and even Michigan have works commenced, in progress or completed ...” – Vermont Chronicle, Apr. 21, 1836 American securities in 1830s “... were subject to less frequent fluctuations in price. This appealed to the British, for they purchased these stocks as a safe and more or less permanent investment and not for speculative purposes.” – McGrane, 1935
  47. 47. ATTITUDES TOWARDS U.S. STATE DEBT BEFORE VS. AFTER 1839 “Pennsylvania ... is the gainer, and her inhabitants will bless the (internal improvement) policy which she is pursuing. Maryland is following fast in the steps of her sister and has in progress works of the grandest order, and benefits of which will be felt by those yet unborn. Virginia, Ohio, New York, New Jersey, and even Michigan have works commenced, in progress or completed ...” – Vermont Chronicle, Apr. 21, 1836 American securities in 1830s “... were subject to less frequent fluctuations in price. This appealed to the British, for they purchased these stocks as a safe and more or less permanent investment and not for speculative purposes.” – McGrane, 1935 “The state loans depend upon banking projects and internal improvements, of which probably, not one in ten, for years to come, will pay its own expenses ... the debtors is at a great distance, compellable to good faith by no law whatever. ” – London Times, Mar.5, 1839 “The plan of constructing works of internal improvement in Indiana is bad ... and the consequence is, that a vast amount of money has to be expended before a single dollar is received. ” – London Times, Oct. 17, 1839
  48. 48. DATA: BOND PRICES Jan20 Jan30 Jan40 Jan50 Jan60 Jan70 50 60 70 80 90 100 110 120 130 OH • Monthly Ohio bond prices in New York market return
  49. 49. DATA: BOND PRICES Jan20 Jan30 Jan40 Jan50 Jan60 Jan70 30 40 50 60 70 80 90 100 110 120 PA • Monthly Pennsylvania bond prices in Philadelphia market return
  50. 50. DATA: BOND PRICES Jan20 Jan30 Jan40 Jan50 Jan60 Jan70 0 20 40 60 80 100 120 IN • Monthly Indiana bond prices in New York market return
  51. 51. DATA: BOND PRICES Jan20 Jan30 Jan40 Jan50 Jan60 Jan70 0 20 40 60 80 100 120 IL • Monthly Illinois bond prices in New York market return
  52. 52. DATA: BOND PRICES Jan20 Jan30 Jan40 Jan50 Jan60 Jan70 65 70 75 80 85 90 95 100 105 110 115 KY • Monthly Kentucky bond prices in New York market return
  53. 53. DATA: COMMODITY PRICES Jan32 Jan34 Jan36 Jan38 Jan40 Jan42 Jan44 80 90 100 110 120 130 • Monthly all-commodity index of wholesale prices for the New York market, Cole (1938)

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